When the hedge fund he founded shorted over $25 billion mortgage securities in the early days of the 2008 financial crisis, John Paulson became a billionaire. Now, he’s looking at “another frothy house market” with a possible repeat of sagging home prices, but maintains that the banking system is much better-positioned to cope with it in an interview with Bloomberg.
Mortgages are of a much higher quality now than they were back in the early aughts; subprime mortgages aren’t even in the market, and FICO scores are strong. Back then, banks were also heavily leveraged, with the average capital in major banks at roughly 3%. And much of that debt was risky, so when the market began to decline, equity fell under pressure and that caused the rapid failure of U.S. financial institutions. While banks recovered, they increased equity so as not to see a repeat of that failure, with most banks at 9% to 12% equity. Because of that shift, the financial system isn’t at risk of collapse as it was in 2008, even with a frothy housing market, Paulson told Bloomberg.
Subprime shorting was “an asymmetrical trade,” Paulson said, and while the economics of it were appealing, getting it right was “like finding a needle in a haystack.” Moreover, investment-grade bonds had never defaulted, according to Moody’s and S&P. However, the issue with shorts is that if they fail—such as what happened with crypto, which kept going higher than people thought it could go—then they’re left scrambling to cover the downside. While short sellers who promote the stock they’re shorting—convincing people to buy it at a high price in order to make profit when it goes down—often get a bad name, Paulson maintains that his subprime short was different, because many of his investors were families, endowments, and pensions that were greatly damaged by the market plunge. He also never promoted the bonds or dealt with retail investors. The banks that bought from them—Goldman Sachs, Deutsche Bank, Morgan Stanley, Credit Suisse and USB—knew exactly what they were purchasing. And while Paulson hit a home run with his subprime short, he says it’s easy to become overly confident and take more risk, which can result in humbling losses.
When asked about gold, Paulson told Bloomberg that while gold is usually a hedge against inflation, current long-term inflation expectations are still low, around 2.5%, causing real rates to turn positive, which has “put a cap on gold.” Gold will likely only rise when long-term inflation expectations rise to a point where people lose faith in the Fed to control it.